Fix Finance by Shedding Light on Its Complexities

Feb. 11 (Bloomberg) -- Economists teach us that a financial
market is a powerful technology for processing information. It
brings everyone’s knowledge and greed into play, devouring every
available scrap of information to achieve optimal risk sharing
and put resources to the best possible use.

That’s the theory. In practice, things often don’t work
that way. The 2008 financial crisis demonstrated that the
information processor, confounded by overly complex securities
and specious AAA ratings, can easily misallocate resources and
ultimately grind to an inglorious halt.

When a technology fails, we naturally look for a fix. If
markets don’t digest information very well, we ought to ask why,
and whether some re-engineering could help them do better. The
idea that a little central planning might help markets will
undoubtedly perturb free-market puritans, but it may be just
what we need.

Let’s start with a simple observation: The overwhelming
complexity of today’s markets renders banks unable to judge
risks as rationally as standard theories of finance assume they
do. The health of any decent-sized financial institution depends
on a vast web of links to other institutions that even the most
sophisticated risk manager cannot hope to penetrate.

Network Interdependence

To make things specific, consider the interbank lending
market, which played a leading role in the financial meltdown of
2007 and 2008. Banks use the market to manage demands for cash
by shuttling funds among themselves, often overnight. If Bank A
wants to judge the risk of lending to Bank B, it’s not enough to
look at its assets and liabilities. If Bank B has loans
outstanding to Bank C and Bank D, its creditworthiness depends
on the state of those banks, too, which in turn depends on that
of other banks to which they have made loans. Given the rich
network interdependence, Bank A can’t possibly gather enough
information to judge Bank B or any other.

Amid this complexity, how can we hope to get a market that
functions? Two European physicists, Stefan Thurner and Sebastian
Poledna, offer a bold idea: Use computing technology to achieve
a radical transformation of banking transparency, turning
information into a public resource and making it much harder for
banks to hide risks.

Here’s how it would work for the interbank market.
Developed-nation authorities, such as the U.S. Federal Reserve
and the European Central Bank, have access to fairly complete
information on who has loaned how much to whom -- just what is
needed to shed light on the broader network. They would use
these data to calculate a measure of risk called DebtRank, which
captures the intuitive idea that the most risky banks are those
that have lots of links to other risky banks. Banks connected to
more banks with high DebtRank scores would naturally have higher
DebtRank scores themselves (see my previous article on the
subject). If the regulators made the results public, then anyone
would, at a glance, gain a much more accurate view of the true
risks associated with any bank.

The second step would involve using the risk assessments to
rearrange incentives. The financial system, as a whole, would be
better off if banks seeking to borrow funds did so from the
least risky banks. To achieve this, regulators could require
borrowers to favor lenders with the lowest DebtRank scores. The
system would punish banks that take on too much risk by
constraining their lending, and would inhibit the emergence of
any single counterparty risky enough to threaten the entire
system (see my blog for further detail).

Simple Changes

Speculative as the idea might seem, it deserves attention.
In preliminary studies using computer simulations, Thurner and
Poledna found that the simple changes would reduce the chance of
widespread banking crises while improving the efficiency of the
interbank lending network. The approach could easily be
generalized to include reporting on links established by credit-default swaps and other derivatives, and perhaps could be
extended to markets more generally, as well.

The beauty of the idea is that it introduces strong
incentives for banks to reduce their systemic risk. Of course,
such an unorthodox solution will almost certainly draw the
criticism of banks and other market participants who profit
precisely from taking on big risks and hiding those risks from
others. But for the rest of us, and for the economy at large,
the added transparency would only bring benefits, and might help
the market live up to its reputation as a powerful processor of
information.

(Mark Buchanan, a theoretical physicist and the author of
“The Social Atom: Why the Rich Get Richer, Cheaters Get Caught
and Your Neighbor Usually Looks Like You,” is a Bloomberg View
columnist. The opinions expressed are his own.)